Since the completion in 1997 of the negotiation of commitments on international trade in financial services under the GATS several organisations and commentators have raised questions as to what prudential measures are covered by the Prudential Defence Measure (PDM) of the Annex on Financial Services of the GATS, and as to whether the PDM together with other GATS rules provide adequate scope for the use of capital controls.
Under the section on domestic regulation of the Annex, according to the PDM, “Notwithstanding any other provisions of the Agreement, a Member shall not be prevented from taking measures for prudential reasons, including for the protection of investors, depositors, policy holders or persons to whom a fiduciary duty is owed by a financial service supplier, or to ensure the integrity of the financial system.” However, the latitude thus provided for regulatory measures is followed by an anti-circumvention qualification:
“Where such measures do not conform with the provisions of the Agreement, they shall not be used as a means of avoiding the Member’s commitments or obligations under the Agreement”.
The inclusion of the PDM in the GATS was the outcome of contentious negotiations during which several developing countries sought substantial freedom from possible challenge under the GATS for prudential measures. The qualified acceptance in the PDM of countries’ right to take prudential measures reflected also the conflict with the dominant view of the developed countries participating in the negotiations regarding the benefits in comparison with the costs of the liberalisation of international trade in financial services, that is to say of both cross-border financial transactions and of restrictions on the commercial presence of foreign financial institutions.
The practical scope of the PDM has been the subject of much disagreement. The definitions of the terms,
“prudential” and “fiduciary”, were left open. This lacuna seemed important primarily with respect to prudential measures. As the Asian financial crisis unfolded during the same period as the completion of the WTO negotiation of commitments on international trade in financial services at the end of 1997, the question arose whether the PDM covered only measures taken to protect financial sectors from collapse during and in the immediate aftermath of the banking crises or whether it also covered prudential reforms undertaken as part of the longer-term restructuring of countries’ banks and regulatory regimes which followed. This question has re-emerged with a vengeance in the context of the massive, long-term restructuring of prudential regimes in response to the fault lines – primarily in the regimes of developed countries – revealed during the current financial crisis which began in 2007.
1 I have discussed some questions concerning the protection accorded by the Annex on Financial Services of the GATS to prudential measures more generally in other recent papers (for example, Cornford, 2012; Cornford, 2012/2013). Except for the question of the protection afforded to controls over cross-border capital movements the principal focus of these papers is microprudential measures, i.e. measures directed at controlling the risks of individual firms with usually only an incidental impact on systemic risks within the financial sector.
3 A second question concerned relations between prudential measures, banking crises, and capital controls.
Although typically imposed in response to balance-of-payments problems, capital controls will generally have effects not only on the country’s macroeconomy but also on its banks owing to the effects of capital inflows and outflows on both the scale and currency denomination of assets and liabilities in banks’ balance sheets. In a report of 2000 a working group on capital flows of the Financial Stability Forum, the predecessor body of the Financial Stability Board (FSB), accepted the idea that there are circumstances in which the introduction of capital controls can be justified as a prudential measure both for macroeconomic reasons (for example, unwanted movements of the exchange rate and consequent complications of domestic monetary policy) and “to reinforce or complement prudential requirements on financial institutions” (Financial Stability Forum, 2000: 34–37).
The connection drawn here between the prudential and the macroeconomic objectives of capital controls would appear to place such controls in the category of macroprudential measures, although
“macroprudential” was not yet a standard term. The working group of the Financial Stability Forum limited its imprimatur to controls over capital inflows. Controls over capital outflows were excluded, not altogether convincingly, on the grounds that these “should be thought of more as an element of crisis management and, as such, are beyond the scope of this paper”.
Since the beginning of the current crisis the official view of the relation between macroprudential measures and capital controls has been clarified and extended.
For example, in a recent document on capital flow management measures (CFMs, the current IMF term for capital controls) and macroprudential measures (MPMs) the IMF draws a distinction between the two on the basis of their primary objectives: “CFMs are measures ... that are designed to limit capital flows, while MPMs are prudential tools that are primarily designed to limit systemic financial risk and maintain financial system stability”. However the IMF also acknowledges that there are situations where CFMs and MPMs overlap: “To the extent that capital flows are the source of systemic financial risks [which they have been in several financial crises], the tools used to address those risks can be seen as both CFMs and MPMs. An example could be when capital inflows into the banking sector contribute to a boom in domestic credit and asset prices. A restriction on banks’ foreign borrowing ... would aim to limit capital inflows, slow down domestic credit and asset price increases, and reduce banks’ liquidity and exchange rate risks. In such cases the measures ... would be considered both CFMs and MPMs” (IMF, 2012: 21).
The IMF now accepts a temporary role for CFMs on capital outflows for countries which face domestic or external shocks which are large relative to the ability of either macroeconomic adjustment or financial sector policies on their own to handle. “When a crisis is considered imminent, CFMs may be desirable if they can help prevent a full-blown crisis” (IMF, 2012: 25). Although in the IMF’s view “the outflow CFMs should always be part of a broader policy package that also includes macroeconomic, financial sector, and structural adjustment to address the fundamental causes of the crisis” [i.e. part of a policy package generally including a number of macroprudential measures], the IMF avoids the use of the term
“macroprudential” in the context of outflow CFMs. Such fine distinctions are likely to be lost outside the institutional setting of IMF discussions with the result that in many situations, and for many people, the terms MPM and CFM are likely to be used interchangeably.
How far are these changing views concerning capital controls and macroprudential regulation accommodated by the rules of the GATS?
Restrictions on capital movements are covered in Articles XI and XII and in a footnote of Article XVI of the GATS. Article XI.2 prohibits restrictions on capital transactions related to a country’s commitments as to market access and national treatment. However, according to Article XII, this prohibition may be overridden by a country’s need to undertake actions to safeguard the balance of payments in the event of serious external financial difficulties. Consultations concerning the need to take such actions are to be based on statistical and other empirical findings of the IMF and on the Fund’s assessment of the
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country’s external financial position. The footnote of Article XVI, which covers the rules for the granting of market access to services suppliers, specifies that capital movements integrally related to commitments regarding cross-border supply of banking services must be allowed, as must transfers of capital related to commitments regarding supply of services through a commercial presence.
In the context of macroprudential policy capital controls may be necessary not only in classical balance of payments crises where the policy challenge is the exhaustion of a country’s foreign-exchange reserves but also for handling difficulties caused by excessive upwards pressures on exchange rates due to capital inflows (as acknowledged in the IMF document quoted earlier). A number of emerging-market countries have experienced such pressures during the current crisis.
Capital controls in response to such pressures have a history which also includes their deployment by developed countries during periods of currency turbulence in the 1960s and 1970s. Capital controls during that period included the requirement of approval, not always granted, for sales to non-residents of German money-market paper and fixed-interest securities issued by German entities with less than four years to maturity; bans on interest on balances held for non-residents at German and Dutch commercial banks, the requirement that Swiss banks charge commissions equivalent to negative interest on deposits owned by non-residents; and discriminatory reserve requirements imposed by Germany, Switzerland and Japan on bank liabilities to foreigners (Mills, 1976: 180–211).
The thinking behind Article XII of the GATS concerns classical balance-of-payments crises. Thus according to Article XII.1 “in the event of serious balance-of-payments and external financial difficulties or threat thereof” restrictions on [cross-border] trade in services are permitted. However, the statement which follows suggests that the Article was intended to be directed at balance-of-payments difficulties associated with capital outflows: “It is recognized that particular pressures on the balance of payments of a Member in the process of economic development or economic transition may necessitate the use of restrictions, to ensure, inter alia, the maintenance of a level of financial reserves adequate for the implementation of its programme of economic development or economic transition”.
Only case law developed through dispute settlement will determine whether the Article XII can justify the deployment of capital controls in the face of difficulties caused by excessive capital inflows as well as by excessive outflows. However, the increased official acceptance of the overlap between prudential objectives and the objectives of the macroeconomic management of balance-of-payments crises would appear to reinforce the scope which GATS rules provide countries for the use of capital controls. Thus, failing justification under Article XII, the implication of the changed official view is that justification of such controls under the PDM would now be more likely to be effective (although uncertainty due to the anti-circumvention provision which follows the PDM would still remain).
These arguments also have implications for bilateral and regional agreements on trade and investment.
If the combination of Article XII of the GATS and the PDM of the Annex on Financial Services does provide scope for the acceptance of capital controls (as suggested above), then in a world where volatile capital movements can pose serious problems for both macroeconomic and prudential policy analogous scope for the deployment of such controls should surely be included in the rules of such agreements.
5 III. DISCUSSION OF MACROPRUDENTIAL MEASURES AND GATS RULES IN THE WTO Uncertainty as to the precise scope of the protection for prudential measures afforded by the PDM has led to much debate to which commentators under United Nations auspices, academic experts and non-governmental organisations have contributed (Cornford, 2012). Such uncertainty also figured in a communication of Barbados to the WTO Committee on Trade in Financial Services (WTO, 2011).
The initiative for the first dedicated discussion of macroprudential issues in the WTO came from Ecuador in early 2012. Consultations with other member countries led Ecuador to conclude that there was no consensus on preparing a legal interpretation of the GATS rules in relation to macroprudential regulation or on analysis in the WTO of specific macroprudential measures. Such alternatives, many countries believed, risked narrowing the scope of the existing rules to the possible detriment of WTO members.
Ecuador’s revised proposal for a free-ranging discussion of the experience of member countries in the implementation of macroprudential policies was subsequently accepted.
The discussion took place at a meeting of the WTO Committee on Financial Services in March 2013.
It was led by Ecuador which described the financial crisis experienced by the country in 1998. The fiscal cost of the bank bail-outs amounted to 30 per cent in a single year and 13 of the 15 banks which received government funds became insolvent. The economy was dollarized and an extensive programme of macroprudential regulation was introduced. This included a constitutional ban on bank bail-outs, the separation of commercial and investment banking, and the establishment of a liquidity fund to perform the functions of lender of last resort and of a fund for deposit insurance. The impression left by Ecuador was that, in view of the inflexibility introduced into its financial system by dollarization and by the ban on bail-outs, the country was conscious of its need for maximum flexibility regarding the other instruments of financial policy in a possible future crisis, including recourse to capital controls.
Two of the countries which explicitly addressed the issue of measures permitted under the PDM were Australia and Canada, both of which expressed the belief that the PDM provided them with the required flexibility for effective prudential regulation. A third was the Republic of Korea (see below).
Other participants in the debate such as Argentina and Brazil expressed concern over volatility of international capital movements since the outbreak of the financial crisis and the resulting need for according countries policy space regarding the use of capital controls. Moreover there was widespread agreement during the debate concerning the need for coordination between the WTO and other bodies responsible for the setting and implementation of financial standards such as the FSB, the Basel Committee on Banking Supervision (BCBS), and the IMF.
An interesting but only briefly fleshed out intervention was made by the Republic of Korea which saw the need for a distinction between ex-ante measures designed to prevent a crisis and ex-post measures designed to address problems due to the outbreak of crisis. The country accepted that the PDM provided sufficiently flexibility regarding ex-ante macroprudential measures. However, it also believed that further discussion was needed on whether the PDM provided sufficient flexibility regarding ex-post macroprudential measures – in particular regarding the issue of whether the measures taken involved the subsidisation of government-owned banks.
The reference here sounds as if it was inspired by the country’s concern as to whether the sort of measures it took in response to its banking crisis beginning in late 1997 would be covered by the PDM. The restructuring programme of the Republic of Korea included mergers, fresh equity injections, enforced redundancies, management reform, and fiscal support through Korea Asset Management Corporation (KAMCO) and Korea Deposit Insurance Corporation (KDIC) which amounted to US$50 million. During the programme many of the financial institutions involved, owing to their insolvency, were effectively government-owned (Golin, 2000: 489–494). The measures taken by the Republic of Korea could be categorised as ex-post macroprudential.
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IV. OMISSIONS FROM THE WTO DISCUSSION
Missing from the exchanges at the WTO was detailed discussion not only of the relation of GATS rules to capital controls but also of several other issues currently being addressed as part of the agenda of macroprudential regulation. The sequel here takes up the implications for the GATS – and by extension for bilateral and regional trade and investment agreements – of two categories of regulation directed at the corporate structure of banks as well as of several measures directed at both banking transactions and the assets and liabilities of cross-border banks.
A. Resolution of cross-border banks
The development of rules for handling insolvencies of banks with cross-border operations is a long-standing item of the agenda of international financial reform. Progress has been slow owing to the difficulty of achieving agreement concerning the required harmonization of significantly different existing national laws and definitions and concerning the distribution of the costs of the insolvencies among the countries in which firms affected by the insolvency have a commercial presence. Development of rules for the cross-border insolvencies of financial firms is closely linked to the regulation of financial firms too big to fail (TBTF), i.e. financial firms whose failure is a source of systemic risk. Classification of a financial firm as TBTF reflects a view of the systemic risk posed by the failure of such a firm, thus making such a failure an issue for macroprudential policy.
Work on cross-border bank insolvencies by the Basel Committee on Banking Supervision (BCBS) and the FSB was given a fillip by experience of such insolvencies of large cross-border banks during the financial crisis. However, although issues connected to bank insolvencies, have been extensively ventilated as part of this work, international agreement is still limited to arrangements designed to smooth resolution when more than one jurisdiction is involved, and does not include an agreed set of model procedures.
Thus the key document of the FSB on resolution regimes (FSB, 2011: 13–15 and Annex I) includes the following principles (home jurisdiction being that of the parent bank of a group of cross border banking entities):
• The mandate of the resolution authority should empower and encourage the resolution authority to achieve a cooperative solution with foreign resolution authorities;
• Regulation should not include provisions that trigger automatic action in response to official intervention or the initiation of resolution or insolvency proceedings in another jurisdiction;
• The resolution authority should have resolution powers over local branches of foreign firms and the capacity to use its powers to support a resolution carried out by a foreign home authority or to take measures on its own initiative where the home jurisdiction is not taking action or is acting in a manner that does not take sufficient account of the need to preserve the local jurisdiction’s financial stability;
• Jurisdictions should provide for transparent and expedited processes to give effect to foreign resolution measures, either by way of a mutual recognition process or by taking measures under the domestic resolution regime that support and are consistent with the resolution measures taken by the foreign home resolution authority. Such recognition or support measures would enable a foreign home resolution authority to gain rapid control over the firm or the assets of the firm that are located in the host jurisdiction in cases where the firm is being resolved under the laws of the foreign home jurisdiction;
• The resolution authority should have the capacity, subject to adequate confidentiality requirements, to share information pertaining to the banking group as a whole or to individual subsidiaries and branches with the relevant foreign authorities where such sharing is necessary for the implementation of a coordinated resolution.
7 In the case of global systemically important financial institutions (G-SIFIs) there are additional provisions concerning the establishment of official Crisis Management Groups with the objective of enhancing preparedness for and facilitating the management and resolution of cross-border crises affecting the firms involved. Key elements of such preparedness are also specified.
But these principles fall short of agreement on the way in which losses should be distributed between
But these principles fall short of agreement on the way in which losses should be distributed between